Bollinger Bands are a common part of the stock market technical analysis used by numerous investors and traders. This tool was developed back in the 1980s by John Bollinger, hence the name. It was designed primarily for stock trading such that it can act as a volatility indicator measuring a stock’s relative high or low price as compared to historical trades. The tool uses standard deviation for measuring volatility. As volatility increases or decreases, so does the standard deviation. The bands expand with a price rise and contract with a price drop.
Bollinger Bands, because of their flexibility, offer investors the flexibility to apply them in trading various securities. Here, we will discuss in detail this tool and explain how it can be used as part of technical analysis for stock market investments.
What do Bollinger Bands involve?
Bollinger Bands mainly comprises of three lines, as noted below:
- the upper band
- middle bank and
- lower band
The upper and lower bands are placed on either side of the middle band or the moving average band. The parameters of the middle band can be selected by the trader. Traders determine the total number of standard deviations that the volatility indicator must be fixed at. This number will then determine the distance between the upper and lower bands from the middle band. By looking at the position of these bands, traders can estimate the strength of the trend and the potential price highs and lows that can be expected in the near future.
How to use Bollinger Bands in technical analysis?
Oftentimes, new investors are on the lookout for answers on how to determine if the price of a stock is relatively high or low? While it is possible to conduct some research around it and decide whether to buy or sell the stock, what is difficult to know is the best time to do so. This is when Bollinger Bands come into picture.
Bollinger Bands can help investors in deciding the right time to buy or sell a stock by looking at the relative strength of a stock price. This indicator can also be applied to the broader market.
The price of a stock is said to be relatively low or attractive if it is closer to the lower band. It may be relatively high or overvalued if it’s closer to the upper band. However, investors need not rely only on the signals of Bollinger Bands for buying or selling stocks. This tool can help them in assessing the relative value of a stock and related information.
Using as price targets
One of the most common ways that investors use Bollinger Bands is by keeping the upper and lower bands as stock price targets. If, for example, the price of a stock bounces back from the lower band and goes above its 20-day average, the upper band is considered the price target on the upside and vice versa. Generally, stock prices keep oscillating between the upper band and the 20-day average when there is a strong uptrend. It will go the opposite way if there is a strong downtrend.
When there is a continued rise in stock price volatility, the gap between the two bands widens and during low volatility periods, the gap between the two bands contracts. Such widening and contractions arrive alternately since volatility is cyclical.
During low price volatility, the Bollinger bands come closer, thereby making the distance from the moving average narrower. This ‘squeeze’ indicates that the market may soon trigger a new trend and allow traders to explore more trading opportunities due to an upcoming expansion phase.
What are the limitations of Bollinger Bands?
While Bollinger Bands can be helpful in technical trading, it has certain limitations that investors must know about.
- One of the limitations of Bollinger Bands is that they are reactive and not predictive. These tend to react to price movements but cannot be used for predicting prices. Therefore, Bollinger Bands are also called a lagging indicator.
- While using these to gauge the price trends, it is important to remember that they cannot be used independently for price predictions. Traders must ideally use this tool in combination with other non-correlated technical tools that offer direct market signals.
- Bollinger Bands do not have any standard settings that can be used by all traders. Every trader who wants to use this method as part of technical analysis must find independent settings, as per the specific stocks included in their portfolio. In case the settings do not work, traders can modify them or switch to a different tool.
Bollinger Bands can be used effectively to identify the relative strength of a stock’s price in the short run. These can also help traders in predicting price trend reversals. While using these, it is important to remember that Bollinger Bands are primarily based on historical information. Hence, these can only react to price movements and should not be used for anticipating future price movements. It is best to use risk-management controls while using Bollinger Bands for trading.
Technical analysis is used for evaluating stock prices and identifying trading opportunities by seeing various price trends on charts. This analysis is based on the historical prices of stocks and can act as a valuable indicator for determining future price movements.
Fundamental analysis is used to determine a stock’s true or “fair market” value. It is mainly used by investors and traders to identify stocks that may be currently trading at lower prices than their true worth.
When the price of a stock goes below the lower Bollinger band, the stock price is said to probably have fallen more than it should have and is likely to bounce. This is called Bollinger bounce, as it helps traders to identify the possibility of price rise.
There are two main Bollinger band signals, M-Top and W-Bottom. M-Top is seen when a stock’s price level goes above the upper band or touches the upper band and then comes back near the middle band. This is a signal of price weakness and a likelihood of prices falling. W-bottom also signals a warning sign of price reversals by coming closer to the lower band and bouncing back to the middle band.